The network of payment obligations amongst firms is inherently interconnected. And, like all systems, the very structure of the system itself often greatly determines the patterns of the parts. These patterns create complex overlapping feedback loops, so it’s hard to map the symptoms of a structure to a single causal factor that created it. As a result, mapping the interconnections of the patterns can be more challenging than just identifying parts, leaving many systems as resistant to analysis as they are to change.
So too, the structure of the money and credit system influences the long term sustainability of the constituent businesses that comprise it. The inevitable feedback loops it produces makes loan default and business failure more common than the free market alone would dictate. If we can analyze how the system itself fragilizes SMEs, we might be able to create a system that more sustainability facilitates trade without leaking too much value to costs of administration and settlement.
We can often be blind to the fragility of certain systems given that we all have the tendency to focus on the quantities in systems and not their quality. This leads us to often overvalue efficiency and undervalue resilience. However, resilience is as important to a system as a foundation is to a house. What good is a system if it cannot bounce back after facing a stressor? A skyscraper that cannot gently sway to absorb wind gusts? A farm that destroys the very topsoil it depends on for its subsistence? Our intense short term focus on the quantifiable can lead us to miss the long term value of systems resilient to shocks.
Ecosystems naturally balance efficiency and resilience to subsist in the present while preserving the future. Bernard Lietaer explains this concept where he writes: "A resilient, efficient system needs to be diverse and interconnected. On the other hand, diversity and interconnectivity decrease efficiency. Therefore, the key is an appropriate balance between efficiency and resilience."
Donella Meadows complements this thought in her book Thinking in Systems where she writes, "A diverse system with multiple pathways and redundancies is more stable and less vulnerable to external shock than a uniform system with little diversity."
So as our natural ecosystems naturally manage risk through several levels of redundancy, perhaps our credit system could be structured differently to reduce late payments and absorb those that cannot be avoided to reduce the systemic risk of chain defaults?
The foundational element of the credit ecosystem is trade credit, a liability of future cash flows for the buyer and an asset to the seller of the same amount. Given that trade credit can be abundantly created by firms in the provisioning of goods with delayed payment terms, the limiting factor in the system is liquidity. To date “liquidity” is often synonymous with cash, but in reality it can be anything that can serve as final payment or settlement.
It is important to take a second to briefly unpack the money creation process, the current dominant liquidity source, and its impact on stocks and flows in the system. While approximately 3% of money is printed or coined, 97% is created as bank debt money. While money for the principal is created as money, the money required to pay the interest is not. As a result the debtor must earn existing principal debt in the system via their sales or the system must take on new debt somewhere. Essentially, either debt grows exponentially in line interest, or some debtors must default. From the start, it is programmed that there will be an artificial scarcity of the main tool we use to settle trades. This leaves us with a brittle foundation for an economy.
Furthermore, SMEs generally have the worst access to bank credit money due to the high cost of underwriting for banks relative to loan size. What credit is available to them often sharply contracts in times of recession, as banks curtail lending and call in debts, and even in times where they have access, loans come with high interest. So, the very source of funds for repayment of trade credit is not only constrained at the source, but is least available when it is most needed.
To compound this problem, not all cash is circulated as a pure medium of exchange, but rather is locked up in bank accounts as a store of value making the outstanding media of exchange more scarce. Not only is it stored away, but this scarce resource slowly flows from borrowing firms’ “stock” via compound interest payments. Just as depreciation drains physical capital, interest is a drain on the stock of working capital available to businesses in an economy to repay their debts.
So in essence, the nature of money creation makes our “stock” of liquidity used for settlement naturally scarce and increasingly so in times of crisis. Cash deviated to serve a savings function or flowing out to banks via interest payments further reduces the available media for settling trades.
The quantity of the stock of money is important, but so is the timing of its flows. Larger firms can often negotiate longer terms on their accounts payable than SMEs can negotiate on their own leaving SMEs susceptible to having low cash on hand. While trade credit is more efficient as a means of coordinating economic activity, the low average level of “stock” working capital and the distance between cash flows out and in can create blockages in payment networks that cannot be resolved with the simple reordering of payments.
This is an existential issue for SMEs. Trade credit is by far the most important form of short term finance for SMEs and non-payment of such credit is the #1 cause given for their default (31%) over poor sales (28%). As a firm’s trade credit portfolio is often concentrated in their industry, within a given geography, or to a smaller group of clients than large businesses, this can lead to contagion risks. This is well covered by Frederic Boissay where he states that if the customers of a sound firm are in distress, the chances the creditor gets into financial trouble ranges from 4.1 to 12.8% (Credit Chains the Propagation of Financial Distress).
The extent to which it can be contained depends on whether or not the firm has the cash on hand to absorb the impact of non-payment without affecting their own suppliers. With this in mind, one can easily visualize the risk of firms with different liquidity profiles. Firms who can cover all obligations without any additional receivables getting paid are considered “liquid”. Those who cannot cover their debts even if their receivables are paid are “unsound” to start and not as relevant for this discussion. However, there is an intermediate group on which we can have an impact - those who can pay their obligations only if their debtors pay up first.
To conclude, the stock of liquidity available to intermediate the exchange of value is constrained at the source by banks, contracted in times of economic duress, flows out with interest, is scarce for SMEs due to timing of flows and is highly correlated to a single industry’s performance. In our next two pieces, we will explain how credit clearing can conserve cash and how mutual credit can be used as a tool to create abundant credit within trusted business circles.